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Is Britain's Economy on the Mend?

After a steady stream of encouraging economic news in recent weeks, Bank of England Governor Mervyn King took pains on Aug. 12 to temper hopes of a rapid recovery. Announcing the results of the BoE's latest quarterly inflation report, King cautioned that the recession was "deeper than feared" at the time of the bank's previous inflation report in May.

The BoE now expects the British economy to bottom out at a 5.5% rate of decline sometime this year before picking up again. Warning that the recovery is likely to be slow and protracted, King says its sustainability "will be affected by necessary balance sheet adjustments of the banking, household, and public sectors."

The big issue is likely to be the risk of deflation—not inflation. The BoE revealed that inflation is likely to stay well under the bank's 2% target possibly until the end of 2012, remaining below 1% for the foreseeable future. It was the aim of keeping inflation on target that led the BoE to surprise the markets by injecting an additional £50 billion ($82 billion) into the country's money supply through asset purchases on Aug. 6 on top of the $207 billion already committed. According to economists at Royal Bank of Scotland (RBS), the move shows the BoE believes the British economy "remains in intensive care and that a bigger defibrillator is needed to help it emerge from the worst downturn for a generation."

Lessons from Japan The bank made its most recent capital injection in part out of fears that Britain could enter into the same kind of deflationary spiral that kept the Japanese economy mired in recession for a decade back in the 1990s. Hoping to avert another such "wasted decade," King says the BoE has consulted with counterparts at the Bank of Japan. The main lesson, he says, is that even with interest rates close to zero, if further stimulus is still needed, "you need to act sooner rather than later."

With interest rates likely to remain at or close to current levels of 0.5%, many economists say the BoE's most powerful remaining lever is pumping more money into the economy. "Our rough-and-ready estimate is a further £50 billion," says Charles Davis, an economist at the Centre for Economics & Business Research, an independent consultancy in London. Bank of England Deputy Governor Charles Bean says the inflation outlook will be key in determining the timing of the bank's withdrawal of its asset-purchase plan. Although King says it is still too early to judge, there are signs the BoE's policy of quantitative easing is beginning to work.

Indeed, in recent weeks there have been several hopeful indicators of economic turnaround. Home prices have stopped their long-running downward slide and are gradually starting to rise. At the beginning of August, the Royal Institution of Chartered Surveyors scrapped its forecast for a 15% fall in house prices this year, predicting instead that prices may actually climb.

A Fragile Recovery? There are also early signs of life in the country's manufacturing and services sectors. The Markit/Chartered Institute of Purchasing and Supply index released on Aug. 3 registered a reading of 50.8—the first time it has signaled expansion since March 2008. And a recent survey from the Confederation of British Industry (CBI) indicates that companies are finding it easier to borrow money.

But recent labor market statistics suggest the recovery is fragile. On Aug. 12, new data from the Office for National Statistics showed that unemployment in Britain is at its highest level in 14 years, as jobless counts grew by 220,000, to 2.435 million, in the three months ended in June. That puts Britain's unemployment rate at 7.8%. The good news, though, is that it was the smallest three-month increase since February, according to economists.

"It's an encouraging sign that the rate of increase in unemployment is moderating, and that the worst of the labor market deterioration may have been passed," say analysts at Credit Suisse (CS). Now policymakers just have to get all the arrows pointing in the same direction.
Capell is a senior writer in BusinessWeek's London bureau

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